Financial security is important throughout international trade transactions alongside large-scale business deals when serving buyers alongside sellers. Business transactions gain security because Letters of Credit establish trust between parties through their protective payment system.

Businesses that engage in international trade, including importers, exporters, and owners, need to understand what is Letter of Credit, its principles, and concepts to secure their monetary interests. The following blog discusses Letter of Credit principles, application procedures, required documents, regulatory formats, payment benefits, and financial costs.

What is a Letter of Credit?

Wondering what is a letter of credit? Through a financial instrument called a Letter of Credit, banks and financial institutions guarantee buyers can pay sellers only after sellers satisfy defined purchase terms and conditions.

Letter of Credit Meaning: It is assumed to operate as trade security instruments used to protect sellers who will receive payment while their buyers receive the purchased products or services. Through their intermediary position between the two parties, the bank reduces the financial risks both buyers and sellers face.

How Does a Letter of Credit Work?

A Letter of Credit as a financial instrument functionally connects four key parties, starting with the importer as a buyer before proceeding to the exporter as a seller and involving an issuing bank and potentially advising or confirming the bank. Here’s how it works:

  1. Agreement Between Buyer and Seller: Two parties in a commercial transaction agree to let an LC facilitate their business deal.

  2. Issuance of LC: The customer receives an LC through their banking institution, which creates a document instructing payment to the seller.

  3. Verification by the Seller’s Bank: The seller's bank double-checks the letter of credit before informing the seller about it being valid.

  4. Shipment of Goods: The seller completes product delivery while sending necessary documents to the bank.

  5. Verification of Documents: The approving financial institution confirms that the presented documents match all the criteria stated in the Letter of Credit.

  6. Payment Processing: Verification success leads the issuing bank to send payment to the seller.

  7. Buyer’s Obligation: The buyer repays the bank as per agreed terms.

Documents Required for a Letter of Credit

Multiple formal documents must be submitted when processing a Letter of Context. While requirements vary depending on the transaction, some commonly required documents include:

  • Commercial Invoice (proof of goods sold and their value)
  • Bill of Lading(shipping document proving goods have been dispatched)
  • Insurance Certificate (for coverage in case of damage or loss)
  • Packing List (detailed list of items included in the shipment)
  • Inspection Certificate (if required for quality assurance)
  • Certificate of Origin (proof of where goods were produced)

How to Apply for a Letter of Credit?

Applying for an LC involves several steps:

  1. Choose a Bank: Choose an authentic bank that specializes in trade finance products.

  2. Fill Out an Application: The application form requires details regarding transaction information, payment circumstances, and needed documentation for review.

  3. Bank’s Assessment: A bank examines the creditworthiness of the potential buyer as part of its review process.

  4. Issuance of LC: After successful approval, the bank transmits a Letter of Credit to the seller's bank.

Types of Letter of Credit (Quick Overview)

International trade requirements define multiple varieties of Letters of Credit (LC). Here’s a brief overview:

  • Revocable and Irrevocable LC: An irrevocable Letter of Credit requires a signed agreement from all parties to become null and void.

  • Confirmed and Unconfirmed LC: When a bank confirms an LC, it adds additional security through a secondary bank's endorsement.

  • Standby LC: When the buyer fails to make their payment, a standby letter of credit ensures the seller receives payment.

  • Transferable LC: A transferable LC enables handlers to pass the currency obligation onto different participating parties or suppliers.

  • Revolving LC: During ongoing business, several transactions can use the same Letter of Credit without needing a fresh payment document.

Advantages of Letter of Credit

Using a Letter of Credit offers several advantages:

  • Security for Both Parties: The banking system guarantees payments to the supplier while delivering the purchased items safely to the customer.

  • Minimizes Risk: Standby LC safeguards businesses against payment failure while preventing delivery failures.

  • Facilitates International Trade: Global expansion becomes possible for businesses through financially secure operations.

  • Customizable Terms: Specific business needs to drive the customization process for terms and conditions.

  • Enhances Credibility: When banks support payment guarantees, clients develop enhanced faith in their mutual financial transactions on both sides.

How Much a Letter of Credit Costs?

A Letter of Credit's acquisition cost depends on the bank fees, transaction quantity, and the documentation's intricacy. Common cost components include:

  • Issuance Fee: Typically 0.75% to 2.5% of the LC value, depending on the bank and location.

  • Amendment Fees: Additional charges for modifications.

  • Confirmation Fees: Extra fees may apply if a second bank is involved.

  • Document Examination Fees: Fees for verifying submitted documents.

  • Swift Charges: Costs related to international banking transactions.

Letter of Credit Sample Templates

Here’s a basic Letter of Credit sample template:

Bank Name & Address Date

To: Seller’s Name & Address

Subject: Letter of Credit No. LC Number

Dear Seller’s Name,

We, Bank Name, issue this irrevocable Letter of Credit in favour of Seller’s Name for the amount of Amount in Currency.

Terms and Conditions:

  1. Payment shall be made upon presentation of the following documents:
    • Commercial Invoice
    • Bill of Lading
    • Packing List
    • Inspection Certificate
  2. Shipment must be made on or before the Shipment Date.
  3. All documents must be presented within [X] days of shipment.

This Letter of Credit is subject to the Uniform Customs and Practice for Documentary Credits (UCP 600).

Sincerely,

Authorized Signature Bank Representative Name Bank Contact Information

How Can Drip Capital Help?

Drip Capital helps businesses with accounts receivable finance by providing quick access to working capital through invoice factoring. This allows businesses to convert outstanding invoices into immediate cash, improving cash flow and ensuring smooth operations. With a simple application process and no collateral requirements, Drip Capital enables SMEs to manage their receivables efficiently while focusing on growth, as it handles collections directly from buyers.

The Letter of Credit is crucial for businesses to reduce transaction risks during global commerce. Learning about Letters of Credit components, requirements, advantages, necessary papers, application methods, and expense structure helps businesses decide effectively. International business parties dealing with imports or exporters can use letters of credit to safeguard their investments while building trust between them. Businesses achieve operational stability through strategic integration of Letters of Credit, enabling secure payment processes across international trade transactions. Before using one, check with your financial institution or bank about suitable LC choices.

Frequently Asked Questions

1. How does a letter of credit help the sellers?

A Letter of Credit provides security to sellers by guaranteeing payment from the buyer’s bank, ensuring they receive funds as long as they meet the agreed terms. This minimizes the risk of non-payment and enhances trust in international trade transactions.

2. When does a beneficiary receive the payment from the bank?

The beneficiary (seller) receives payment once they submit the required documents proving compliance with the Letter of Credit’s terms. After verification, the issuing or confirming bank processes the payment within the specified timeline.

3. What type of collateral is required to open a letter of credit?

The collateral required depends on the bank’s policies and the buyer’s creditworthiness. Some banks may require cash deposits, business assets, or a bank guarantee, while others may issue an LC based on the buyer’s credit standing.

4. What Is the Difference Between a Commercial Letter of Credit and a Revolving Letter of Credit?

A Commercial Letter of Credit is used for one-time transactions, ensuring payment for a specific purchase. In contrast, a Revolving Letter of Credit is designed for multiple transactions over a set period, eliminating the need to issue a new LC for each trade.

5. Can a letter of credit be cancelled?

A revocable Letter of Credit can be cancelled or modified by the issuing bank without prior consent from the beneficiary. However, an irrevocable Letter of Credit cannot be cancelled or changed unless all parties involved agree. Most LCs issued today are irrevocable for added security.